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Unfunded Pension Liabilities Mount But San Jose Offers Hope

The shadow of unfunded public pension liabilities casts a menacing cloud over the otherwise mostly bright futures of U.S. states and municipalities. The situation is gravest in Illinois, where court rulings have stymied legislative attempts at reform, but a score of states and a slew of cities also face significant challenges from unfunded pension liabilities.

Against this backdrop, a recent settlement in San Jose with union officials on a disputed voter initiative known as Measure B may show at least a partial way out of the public pension morass in which many states and cities are trapped.

Although a few states are doing well, a report by the Pew Charitable Trusts and an analysis of California public pensions from the Public Policy Institute of California (PPIC) paint an overall bleak picture. Pew found that the nation’s state-run systems had a $968 billion shortfall in 2013 — the last year for which complete data is available — that rose to more than $1 trillion if municipal liabilities were included. Furthermore, the systems as a whole are headed in the wrong direction, adding $54 billion to the debt from the previous year.

There is a Washington anecdote, probably apocryphal, that President Harry Truman once said he wanted a one-armed economist. An aide asked why. “Because economists are always saying ‘on the one hand, and on the other,’” Truman supposedly replied.

“On-the-one hand, on-the-other” pretty well describes the latest PPIC findings about California’s public pension liabilities. The good news is that investment returns have been higher than expected. The less good news is that the Golden State’s two largest pension funds, the California Public Employee Retirement System (CalPERS) and the California State Teacher’s Retirement System (CalSTRS) show unfunded liabilities of $62 billion and $74 billion, respectively, for the 2013 fiscal year.

Liabilities have continued to soar because the pension funds are structurally underfunded, a fancy way of saying that state employees and teachers don’t contribute enough to keep them solvent. Demographic factors are also at work. The PPIC report found that the percentage of adults aged 65 and older increased from 9 percent of the population in 1970 to 13 percent in 2013 and is projected to be 17 percent in 2025. This is a recipe for eventual fiscal calamity.

While public unions downplay the significance of unfunded liabilities, saying they are not as onerous as bonded debt, some pension scholars claim they’re worse. “For citizens and taxpayers, unfunded pension liabilities are actually more of a burden than bonded debt,” David Crane of the Stanford Institute for Policy Research told the Orange County Register. He observed that pension liabilities have a higher priority in bankruptcy proceedings than any other kind of debt and usually must be repaid first.

States can’t go bankrupt under federal law, but cities and other local government entities are allowed to do so in many states. Orange County, California, went bankrupt in 1994. Detroit, in 2013, was the largest U.S. city ever to go bankrupt. The financial condition of Chicago, the nation’s third most populous city, is shaky. According to Governing magazine, 36 cities, towns, and other governmental units have filed for bankruptcy since 2010.

In this context, city officials in California and pension reformers everywhere can take modest comfort from an agreement announced in San Jose last month by Mayor Sam Liccardo. San Jose voters in June 2012 approved Measure B, which rolled back retirement benefits. It gave city workers a choice of paying more into their pension funds or receiving a reduced pension. Public unions sued, and a judge struck down that section of the measure. Her ruling was under appeal when the city reached a settlement with unions representing police and firefighters that is expected to serve as a template for similar agreements with other city unions.

Both sides put on happy faces after the settlement, stressing what they had won. For the city and the pension reformers, this meant scaling back pensions for new hires and eliminating bonus checks for retirees. For the unions, it meant preserving pensions for previous hires and eliminating the key requirement that retirees contribute more to their pensions. Disability payments that would have been cut by Measure B were preserved, but future disabilities will have to be certified by a physician rather than by a board on which the union is represented.

Given past rulings of the California Supreme Court, the San Jose compromise was probably the best that reformers could have hoped for. The state’s high court has held that the California Constitution provides extraordinary protection for pensions. Once a worker is hired, his or her pension status is inviolate.

The legal find that public pensions are set in stone sets them apart from other issues. Other laws that prove too costly can be changed. But the Legislature and local governments don’t have that alternative with pensions, which in California are more generous for public employees than for most of their counterparts in private industry. In 1999, when the stock market was booming, the Legislature passed SB 400 at the behest of Gov. Gray Davis (D), reducing the retirement age for state workers from 60 to 55 with pensions paying 2 percent of salary for each year worked and basing pensions on the highest single year’s salary rather than the previous average of three years. The state standard was widely copied by local governments, which in many cases made benefits retroactive.

Small wonder that Crane calls SB 400 “the single greatest issuance of debt in state history.” In 2003, the unfunded liabilities of the 80 public pension systems in California totaled $6.3 billion. By 2004, with the new provisions in effect, it had reached $50.9 billion. By 2013, it had topped $198 billion.

California’s situation on public pensions, dire as it is, pales in comparison to Illinois, the Greece of American states. The Prairie State ranks dead last in fiscal health among the 50 states and has unfunded public pension liabilities of $164 billion. The liabilities for Chicago’s four pension funds and a teacher’s fund amount to another $20 billion. According to Pew data, Illinois public workers contribute only 39 percent of the money needed to fund their pensions.

For years, pension reformers in Illinois were thwarted by the Democratic-controlled Legislature, which was too often in thrall of the public unions. By 2013, however, the state’s sagging credit ratings induced previously resistant Democrats to raise the retirement age for public workers and reduce cost-of-living increases for retirees. In 2014, the Legislature passed another measure that reduced cost-of-living increases for retired Chicago city workers and increased their contributions to pension funds.

The legislative turnaround went for naught. In May the seven-member Illinois Supreme Court unanimously struck down the 2013 law with an Olympian pronouncement. “Crisis is not an excuse to abandon the rule of law,” the court said. “It is a summons to defend it.” Then last month, Cook County Judge Rita Novak overturned the 2014 law for Chicago city workers, brushing aside a plea from Mayor Rahm Emanuel. Gov. Bruce Rauner (R) now proposes a state constitutional amendment that would allow pension cuts for state and city workers. But passage requires a three-fifths favorable vote both by the Legislature and the public, unlikely in a Democratic-leaning state with activist labor unions.

The U. S. federal system allows much leeway to state courts. As with Illinois and California, courts in Arizona, New York and Oregon have barred reducing existing pension benefits. Courts in Colorado, Minnesota, New Mexico and South Dakota have permitted such reductions.

This patchwork of judicial decisions contributes to an enormous variance among states and municipalities in the health of their pension funds, some of which suffer from insufficient contributions, missed payments or poor investment performance. The Pew report found that only 22 of the 50 states fully fund their pension systems.

The plight of underfunded public pension systems is likely to become worse as members of the Baby Boom generation retire and the number of retirees in relation to the number of workers accelerates. Addressing this issue is one of the great political challenges of our time, for Social Security as well as state and local pension funds.

There is no one-size-fits-all solution. But the common sense displayed by city officials and union leaders in the San Jose settlement on Measure B, copied Aug. 5 in an agreement negotiated by Los Angeles with its municipal workers,provides a modicum of hope. Protecting current retirees while also requiring higher pension contributions by future hires is a step down a promising path toward the elusive goal of fiscal solvency. What happened in San Jose is worth emulating.